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U.S. Lubes, L.L.C. v. Consolidated Motor Oils

SUPERIOR COURT OF NEW JERSEY APPELLATE DIVISION


January 16, 2008

U.S. LUBES, L.L.C., PLAINTIFF-APPELLANT,
v.
CONSOLIDATED MOTOR OILS, INC., PAUL SHAPIRO AND INKA SHAPIRO, DEFENDANTS-RESPONDENTS.

On appeal from the Superior Court of New Jersey, Chancery Division, Middlesex County, Docket No. C-268-04.

Per curiam.

NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE APPELLATE DIVISION

Submitted December 5, 2007

Before Judges Cuff, Lisa and Simonelli.

Plaintiff, U.S. Lubes, L.L.C., initiated this action against defendants, Consolidated Motor Oils, Inc., Paul Shapiro and Inka Shapiro, seeking injunctive relief and damages arising out of an alleged breach by defendants of provisions in agreements by which defendants sold their business to plaintiff. Defendants counterclaimed, alleging they were entitled to damages caused by plaintiff's breach of the agreements. Following a three-day bench trial, Judge Chambers issued a written decision on June 14, 2006 and entered a corresponding final judgment on August 17, 2006.

She found that defendants violated the non-competition provisions in the agreements, thus justifying plaintiff's termination of the agreement that provided for an ongoing relationship between the parties, under which defendants would have been entitled to additional remuneration. However, the judge found that plaintiff failed to prove damages caused by defendants' breach, and therefore did not award any damages to plaintiff.

With respect to defendant's counterclaim, the judge found that plaintiff breached a provision in the agreements requiring the payment of commissions (which was undisputed), and awarded judgment to defendants on that claim in the amount of $24,390. The judge further found that plaintiff breached the covenant of good faith and fair dealing, and awarded defendants $42,575.70 on that claim. The judge rejected the remaining aspect of defendants' counterclaim, which sought damages for additional remuneration under the agreement providing for an ongoing relationship. This relief was denied based upon the finding that, because of defendants' breach of the non-competition provisions, plaintiff was justified in terminating the agreements.*fn1

Plaintiff appeals. It argues that the judge erred in determining that it suffered no damages as a result of defendants' breach of the non-competition provisions. More particularly, it argues that the judge erred in finding that plaintiff abandoned the customers to whom defendants sold product in violation of the non-competition provisions. Plaintiff further argues that the judge erred by awarding damages to defendants based upon a breach of the covenant of good faith and fair dealing because (1) plaintiff's pricing decisions were legitimate business determinations, not made in bad faith, and therefore did not constitute a breach of the covenant, and (2) defendants should have been barred from recovery under the doctrine of unclean hands. We reject plaintiff's arguments and affirm.

Defendant, Consolidated Motor Oils, Inc., was a wholesale distributor of petroleum-based products, operated since 1975 by defendants, Paul Shapiro (the sole shareholder) and Inka Shapiro, his wife. Plaintiff is the nation's largest distributor of Citgo products. Ninety percent of plaintiff's sales are Citgo products. Robert K. Smith, president of plaintiff, entered the petroleum business in the 1980s. He was familiar with defendants and their business. From time to time, he and Paul Shapiro had conversations about Shapiro selling his business. In 2001, at age sixty-three, Shapiro believed the time was ripe, and the discussions became more serious.

On October 17, 2001, with both sides represented by counsel, the parties entered into an Asset Purchase Agreement and a Services Agreement. The principal asset defendants were conveying was their customer list. They also conveyed their rights under certain contracts with customers and certain equipment.

In return, plaintiff agreed to make an initial payment of $50,000 for the assets, which was paid and is not in dispute. Plaintiff also agreed to pay an additional $50,000 one year later, provided, that, if the number of gallons of Products which the Purchaser shall sell to persons or entities named on the Customer List (the "Customers") during the period commencing on the Closing Date and ending on October 16, 2002 (the "Actual Sales"), shall be less than 145,000, the amount to be paid to the Seller on November 15, 2002 shall be reduced by an amount equal to (i) the difference of 145,000 minus the number of gallons of Products of Actual Sales, multiplied by (ii) $0.65.

The Asset Purchase Agreement contained a non-competition clause, prohibiting defendants from soliciting customers to buy products from anyone other than plaintiff for five years. However, the Asset Purchase Agreement contained another provision that authorized defendants to sell existing inventory in the ordinary course of business for six months, followed by a ninety-day period during which they could sell remaining inventory "in bulk or otherwise." This provision was in recognition of the fact that plaintiff did not purchase defendants' inventory, but the contractual provision gave plaintiff the right to purchase from that inventory. The provision also obligated defendants to sell the inventory, with notice to plaintiff, to customers on the customer list.

The Services Agreement established an ongoing relationship, in which defendants would be independent contractors obligated to assist plaintiff in developing the customers on the customer list and to use their best efforts to convert the customers to plaintiff's product lines, including, of course, its major line of Citgo products. This agreement was also for a five-year term. It contained a non-competition clause similar to that in the Asset Purchase Agreement, except that the duration of that provision would extend two years beyond the Services Agreement's termination date.

Under the Services Agreement, defendants would be paid commissions based upon gross sales they procured for plaintiff, at the rate of 5% for non-bid sales (to private sector purchasers) and 3% on bid sales (to governmental entities). Defendants would also receive expense money, including a $125 per week automobile allowance and health insurance coverage. They would receive a $3000 per month draw against these obligations, which would be adjusted periodically depending upon the amount of the commissions earned.

Upon entering into the agreements on October 17, 2001, plaintiff sent a letter to the customers on the list, announcing the merger of Consolidated Motor Oils, Inc. with U.S. Lubes, L.L.C., and stating, "We will make every effort to continue the level of service you are used to as well as the quality products Consolidated Motor Oils has provided." The letter further advised the customers that the Shapiros would continue to be their supplier and service their needs. That letter was followed two days later by a letter from defendants, signed by Paul and Inka Shapiro, confirming the merger and advising that they would continue to serve as the customers' sales representatives and that "[t]here will be continuity of case goods brands for those customers using the Nationally advertised oils."

It is useful to note at this point that plaintiff's operation was much larger than defendants', and plaintiff dealt primarily in bulk goods, whereas defendants dealt with smaller customers primarily in case goods. For that reason, plaintiff did not choose to acquire defendants' inventory, which consisted primarily of case goods. As part of the purchase process, plaintiff conducted due diligence, reviewing the records of defendants' operation, and was on notice of the nature of the business it was acquiring. Further, Smith was personally familiar with defendants' business over the years.

Because of the nature of defendants' operation, run primarily by husband and wife, it operated on a low overhead and could be and was profitable with relatively low gross profit margins. Plaintiff, on the other hand, had many employees and vehicles and ran with a high overhead. Accordingly, it required a relatively higher gross profit margin in order to achieve reasonable net profits.

However, in the course of negotiations plaintiff did not disclose to defendants the gross profit margins upon which it would insist for sales arranged by defendants. The 145,000 gallonage figure in the Asset Purchase Agreement was based upon actual sales by defendants in the year preceding the transaction, and it provided the basis upon which defendants reasonably expected they could achieve that level of sales in the next year, and therefore obtain the remaining portion of the sale price, namely an additional $50,000.

Within a few months after the sale, defendants realized that many of the sales of their inventory they proposed to plaintiff were rejected by plaintiff because the sale prices were too low to satisfy plaintiff's expected gross profit margins of at least 30%. Therefore, defendants continued to sell product to these customers out of their existing inventory. Later, after the six or nine-month period during which defendants were authorized to sell their existing inventory, defendants began to replenish inventory for the purpose of achieving sales to customers that were declined by plaintiff because of the low profit margins.

In 2004, plaintiff became aware that defendants were continuing to sell to some customers on the list. In October 2004, plaintiff informed defendants that due to their breach, the Services Agreement was terminated. Plaintiff then filed this action.

At trial, plaintiff asserted entitlement to $40,498 in lost profits damages. This sum was based on the gross profits achieved by defendants, with a margin of 23.6%, which was further adjusted to account for the shipping costs plaintiff would have incurred and the commissions it would have been required to pay defendants. The period during which the lost profit calculation was made spanned from six months after the closing date until termination of the Services Agreement. The claim was based upon the review by an accounting expert of defendants' records during that period.

Defendants claimed entitlement to unpaid commissions of $24,390, which plaintiff did not dispute. Defendants further sought payment of the portion of the $50,000 payment due in accordance with the gallonage formula in the Asset Purchase Agreement, plus $97,000, representing the amount they projected they would have received for the two years remaining on the Services Agreement at the time it was terminated.

Judge Chambers concluded that defendants violated the non-competition provisions in the agreements by selling to customers on the list and new customers beyond the six or nine-month period provided for in the Asset Purchase Agreement. Therefore, she concluded that plaintiff was justified in terminating the Services Agreement in October 2004. As a consequence, defendants were not entitled to the $97,000 they claimed they would have earned after October 2004 if plaintiff had not terminated the agreement.

However, Judge Chambers further found that by its conduct plaintiff abandoned the customers for which it declined to make sales through defendants' efforts. She found that U.S. Lubes refused to sell to these customers because the gross profit margin was too low. She found that the customers would not have agreed to plaintiff's terms, namely higher prices. Therefore, plaintiff was "unable to prove with reasonable certainty that it would have received these sales or their equivalent if [defendants] had not breached the contract."

The judge further found plaintiff's damage claim flawed because it relied upon the amount of profits earned by defendants as its basis. The proper measure of damages must be based upon the amount plaintiff would have earned in the absence of defendants' competition. The judge concluded that plaintiff "would not have secured these customers and earned these profits even if defendants had abided by the non competition clause." She therefore declined to award damages to plaintiff based upon defendants' breach of the non-competition provisions.

Based upon the gallonage formula in the Asset Purchase Agreement, defendants claimed entitlement to $42,575.70 of the potential second $50,000 portion of the consideration for the purchase of their assets.*fn2 Defendants acknowledged that they did not sell the gallonage that would support this claim through plaintiff. However, defendants claimed they were wrongfully precluded from doing so by plaintiff, thus frustrating their ability to enjoy the benefit of their bargain under the agreements.

Judge Chambers agreed. She noted that the 145,000 gallon standard provided for in the agreement set a realistic expectation for defendants based upon their sales in the prior year. The inability of defendants to achieve that level was caused by plaintiff's rejection of sales proposed by defendants. The judge found that the proposed sales were at reasonable prices that would have been profitable for plaintiff, even though below the gross profit margins upon which plaintiff insisted. The judge concluded that the pricing policy imposed by plaintiff, which was undisclosed during the negotiations or in the agreements, destroyed defendants' opportunity to receive the benefits of the contract. The judge explained it this way:

When [plaintiff] entered into the Asset Purchase Agreement, it had access to [defendants'] sales records, and it knew the kinds of purchases [defendants'] customers made. It also knew that [defendants'] annual sales were in the vicinity of 145,000 [gallons] which is why that number was selected as the gallonage requirement governing the second $50,000 payment. By so rigidly rejecting many of [defendants'] proposed sales on the basis that the gross profits on the sales were not high enough, [plaintiff] prevented [defendants] from reaching the gallonage requirement thereby preventing it from receiving any of the $50,000 payment. This court finds based on this record and after weighing the credibility of the witnesses that these proposed sales would not have harmed [plaintiff], that is [plaintiff] would not have lost money if it had gone forward with these sales. It merely would not have made as much money as it would have liked. Further, denying these proposed sales enabled [plaintiff] to avoid the $50,000 payment. Under these circumstances, this court finds that it was a breach of the covenant of good faith and fair dealing for [plaintiff], during that first year when the $50,000 was being earned, to unilaterally reject the proposed sales.

Accordingly, this court finds that defendant[s] [are] entitled to damages in the amount of $42,575.70, a calculation under the provisions of the Asset Purchase Agreement, taking into account the abandoned customers.

On appeal, plaintiff argues that the judge erred in finding that plaintiff abandoned the customers for whom sales proposed by defendants were rejected. Judge Chambers' finding that the customers were abandoned is supported by substantial credible evidence in the record, Rova Farms Resort, Inc. v. Investors Ins. Co. of Am., 65 N.J. 474, 484 (1974), and we have no occasion to interfere with that finding on appeal. We also agree with the judge's legal analysis underpinning the denial of damages to plaintiff, notwithstanding defendants' breach of the non-competition provisions.

In the case of a breach of contract, "'the function of damages is simply to make the injured party whole.'" Furst v. Einstein Moomjy, Inc., 182 N.J. 1, 13 (2004) (quoting Cox v. Sears Roebuck & Co., 138 N.J. 2, 21 (1994)). In other words, "the innocent party must be given the 'benefit of his bargain' and placed in 'as good a position as he would have been in had the contract been performed.'" Ibid. (quoting Scully v. US WATS, Inc., 238 F.3d 497, 512 (3d Cir. 2001)). "[U]nder the Restatement, the innocent party has a right to damages 'based on his expectation interest as measured by . . . the loss in the value to him' caused by the breaching party's nonperformance." Ibid. (quoting Restatement (Second) of Contracts § 347 (1981)).

Damages for breach of an agreement not to compete are measured by the "loss" sustained by the plaintiff due to the defendant's breach, not by the profits made by the defendant. Barr & Sons, Inc. v. Cherry Hill Ctr., Inc., 90 N.J. Super. 358, 374-75 (App. Div. 1966). Profits made by the defendant will only be the measure of the plaintiff's damages if the plaintiff would have earned them but for the defendant's violation of the non-competition clause. Id. at 375.

If it is determined that the plaintiff would have earned the profits earned by the defendant, then the defendant's profits will serve as direct proof of the plaintiff's losses, and will be recoverable as damages. Ibid. In cases involving alleged violations of agreements not to compete, damages do not have to be proven to a mathematical certainty, but to a reasonable certainty. Id. at 376.

Application of these principles to Judge Chambers' well-founded factual findings, supports the conclusion that plaintiff failed to establish it would have made sales to the abandoned customers, and it therefore failed to prove a reasonable certainty of any lost profits.

We next address the award of damages to defendants' based upon plaintiff's breach of the covenant of good faith and fair dealing. Plaintiff, quoting Wilson v. Amerada Hess Corp., 168 N.J. 236, 251 (2001), argues that the judge erred in finding that plaintiff breached the covenant because defendants did not carry their burden of proving that plaintiff acted "'arbitrarily, unreasonably, or capriciously, with the objective of preventing the other party from receiving its reasonably expected fruits under the contract.'" Specifically, plaintiff contends that the agreements authorized it to set prices and its pricing decisions were genuine business decisions. Defendants respond that plaintiff abandoned many of defendants' customers, making it impossible for defendants to reach the 145,000 gallon mark established in the agreements.

Although "[c]courts generally should not tinker with a finely drawn and precise contract entered into by experienced business people that regulates their financial affairs," it is well-settled that "[e]very party to a contract . . . is bound by a duty of good faith and fair dealing in both the performance and enforcement of the contract." Brunswick Hills Racquet Club, Inc. v. Route 18 Shopping Ctr. Assocs., 182 N.J. 210, 223-24 (2005). In other words, "[a] covenant of good faith and fair dealing is implied in every contract in New Jersey." Wilson, supra, 168 N.J. at 244. Therefore, every contract contains "an implied covenant that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract." Id. at 245 (citation and internal quotation marks omitted).

Implied covenants are as effective as express contractual provisions, but they cannot override an express term. Id. at 244. However, a party's performance can violate the implied covenant of good faith and fair dealing, even though it does not necessarily violate an express term. Ibid. Indeed, a party may violate the implied covenant of good faith and fair dealing by performing its obligations under an express term of the contract. Ibid.

In the context of this case, these principles apply:

[A] party exercising its right to use discretion in setting price under a contract breaches the duty of good faith and fair dealing if that party exercises its discretionary authority arbitrarily, unreasonably, or capriciously, with the objective of preventing the other party from receiving its reasonably expected fruits under the contract. Such risks clearly would be beyond the expectations of the parties at the formation of a contract when parties reasonably intend their business relationship to be mutually beneficial. They do not reasonably intend that one party would use the powers bestowed on it to destroy unilaterally the other's expectations without legitimate purpose. [Id. at 251.]

We find no error in Judge Chambers' conclusion that, applying these principles, plaintiff acted arbitrarily and unreasonably in its pricing policies. This is because, through its due diligence review of defendants' business activities, and its personal knowledge of those activities, it was well aware that defendants operated at a much lower gross profit margin than it intended to impose. It did not disclose the profit margin upon which it would insist. The 145,000 gallon standard was based upon the actual experience in defendants' business operations at the lower profit margins. Therefore, plaintiff knew, but did not disclose, that its pricing policies would make it impossible for defendants to achieve the contractual gallonage standard and therefore be deprived of the fruits of their bargain.

Applying the same analysis, we reject plaintiff's unclean hands argument. Although defendants breached the non-competition provisions by making sales independent of plaintiff, they did so with respect to customers rejected by plaintiff based upon an undisclosed term in the agreements that frustrated defendants' reasonable expectations. This would not have occurred if plaintiff had performed its obligations under the contract in good faith.

For the reasons expressed by Judge Chambers in her thorough and well-reasoned written decision of June 14, 2006, as supplemented by this opinion, the judgment of August 17, 2006 is affirmed.


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